Published in:Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP ; No. 16/2016
Extent:
1 Online-Ressource (25 p)
Language:
English
DOI:
10.2139/ssrn.2834798
Identifier:
Origination:
Footnote:
Nach Informationen von SSRN wurde die ursprüngliche Fassung des Dokuments March 10, 2017 erstellt
Description:
This paper puts forward a theory to explain the relationship among the spot exchange rate, the forward exchange rate and the interest differential between two countries in the presence of counterparty credit risk and funding liquidity risk. We argue that covered interest parity deviations reflect the different risks involved in uncollateralized money market transactions and collateralized foreign exchange (FX) swap transactions. To align the risks, we postulate that the FX swap dealer behaves as if he tries to filter out the counterparty credit risks embedded in money market rates in pricing FX swaps, leaving the risk-free rates and funding liquidity risks to be the key considerations. Our empirical results suggest that he does so not only after but also before the global financial crisis. The theory also uncovers a simple way to disentangle counterparty and liquidity risk premiums embedded in money market rates